Short-run Phillips curve & the long-run Phillips curve - Essay Example

Unit VII Assessment Unit VII Assessment Question Explain how the short-run Phillips curve, the long-run Phillips curve, the short-run aggregate supply curve, the long-run aggregate supply curve, and the natural rate hypothesis are all related. How do active and passive views of these concepts differ? The Philips Curves are fundamental to the study of economics. The Curves represent the relationship between inflation and unemployment rates and, they have cross relationships with aggregate supply curves.

Both the long-run Philips Curve and long-run supply curves are vertical. This reveals that monetary policies only affect nominal variables but have minimal effect on real variables such as unemployment and output. In the long-run, unemployment and output remain in their natural state regardless of the imposed monetary policies. Thus, in the long-run, only a single rate of unemployment (“natural” rate) is consistent. This concept of money neutrality implies that the rate of money supply cannot have any effect on long-term supply (McEachern, 2012).

These Philips Curves and the aggregate supply curves have these implications. Indeed, the curves have similar predictions on the nature of unemployment and money supply within an economy. Question 2: Explain why the Fed can attempt to target either changes in the money supply or changes in interest rates, but not both. The Federal Reserve (Fed) is a system that controls monetary and financial systems and activity within the US. The Fed cannot target both the interest rates and money supply simultaneously.

This because whenever the Fed tends to concentrates on a particular variable; it loses its control over the other. For example, if fed targets money supply, it loses its strict control of the interest rates and this can cause interest rate volatility (Bade, & Michael, 2002). Consequently, when fed targets interests rates, it loses control of MS (monetary supply) restrictions. The fed often prefers controlling interest rates to monetary supply. This is because the approach avoids conflicts with the congress that would result from escalating interest rates.

Moreover, interest rates are indicators of future economic advancements. Question 3: How does monetary policy affect aggregate demand in the short run? How does monetary policy affect aggregate demand in the long run? The fed controls the supply of money through monetary policies that include open-market operations, varying reserve requirements, and changing discount rates. Each of these affects the supply of money, which in turn affects aggregate demand. On the other hand, aggregate demand is the total demand of final goods and services that a country is willing and able to consume.

Monetary policies determine liquidity or amount of money in circulation. This determines people’s disposable income and subsequent purchasing power. For example when people are uncertain about their economic future, they tend to increase their savings while they decrease their spending (McEachern, 2012). Thus, on the long run, monetary policies determine spending behaviors among the people. Consequently, the policies affect the level of investments within a country. For example, when interests rates are low people will tend to increase investment due to low borrowing costs.

Question 4: Explain how an active policy differs from a passive policy. The federal government can steer the economy from different approaches. The monetary policies are an example of the approaches that the government utilizes to adjust the economy. The mode of application of either of the tactic determines whether the government utilizes an active or a passive approach. Thus, active policies are taken as a response towards an economic condition. Through active policies, the federal government responds to economic occurrences through a specific policy.

In spite of being applicable, active policies are open to various difficulties due to their reliance on action and experience of the policymakers. Weaknesses of such policymakers can be translated into the resultant policy, leading to a bigger problem. In contrast, passive policies are conducted according to preset rules or regulations. Under this system, rules account for various microeconomic variables and dictate the best course of action in either of the situations (McEachern, 2012). The main advantage of passive policies is that it encompasses the short-term desires of policy makers.

Thus, policy makers are only expected to implement the already set policies rather than creating new ones. Question 5: What is meant by the demand for money? Which way does the demand curve for money slope? Why? The concept of demand for money is a significant aspect of the Keynesian analysis. According to the Keynesian theorists, demand for money does not indicate actual money balances that people hold, but the money balances that they would wish to hold (Bade, & Michael, 2002). Money is not only required for spending but it can also be acquired as a sign of wealth or an asset.

In this sense, demand for money is inversely proportional to the rate of circulation. The demand curve for money has a negative slope (slope downwards). This is due to the costs and risks associated with holding money. Thus, if risks associated with financial assets such as stock increases, people will redeem their stock for cash, thereby increasing demand for money. Interest rates determine the cost of money. Therefore, demand for money varies with the increase and decrease of interest rates.

References Bade, R. & Michael, P. (2002). Foundations of Microeconomics. Boston, MA: Addison-Wesley McEachern, W.A. (2012). ECON Macro 3 (3rd ed.). Mason, OH: South-Western